Morgan Stanley
  • Wealth Management
  • Jul 9, 2019

U.S. Markets May Be More Fragile Than They Seem

The S&P 500 recently reached an all-time high, but investors may be overlooking some economic warning signs.

No sooner did the S&P 500 reach a new all-time high than a surprisingly positive economic report—June non-farm payrolls, released last Friday—started a downtrend. The government reported that 224,000 jobs were added last month, vs. economists’ consensus estimate for a gain of 160,000. June’s number represented a sharp rebound from May’s 75,000 reported new jobs, which had set off fresh concerns over the health of the U.S. economy.

While we’ve only seen a brief dip in stocks so far, the decline in the face of positive economic news shows how fragile markets have become. Stocks dipped largely because the positive report makes it less likely that the Federal Reserve will cut interest rates as much as expected at its meeting later this month.

Meantime, most economic readings continue to weaken and many recession indicators are flashing yellow. For example, The New York Federal Reserve’s model forecasting probability of recession in the next 12 months hit 33% for June. That’s up from 28% in May and the highest level since 2009. It has accurately predicted a recession every time it has exceeded 30%.

Most investors haven’t adjusted their expectations to this new reality. In my view, many investors have become too reliant on expectations that global central bankers, including those from Europe and Asia, will stimulate their respective economies to forestall further weakness. I think it’s best for investors to remain cautious. Here’s why:

  • Corporate earnings may disappoint: Current consensus expectations project a 2.4% year-over-year contraction in second-quarter earnings, according to FactSet. Judging from the recent weakness in new orders reported in the U.S. Manufacturing Purchasing Managers Index, it may get worse. This measure is a leading indicator for S&P 500 profits. Many investors are expecting a second half 2019 rebound in earnings, but I believe it may not materialize.
  • Some asset classes are signaling recession: Interest rates, currencies and commodities are all telegraphing a pending recession. Gold prices, for example, which typically rally when investors are worried about the future, have hit a six-year high.
  • Trade protectionism isn’t having the desired effect: The recent “truce” with China doesn’t change the basic economic facts: Tariffs are proving a drag on global growth and the trade deficit is widening. Last week’s report showing imports are growing faster than exports suggests that trade policies will likely continue to drag on GDP growth this year.
  • The yield curve remains inverted: This means that short-term bond yields are higher than long-term yields, a rare occurrence that most economists consider to be one of the most reliable indicators of a pending recession. Currently, three-month Treasury bills are yielding more than 10-year notes for the sixth consecutive week. The longer this inversion lasts, the more reliable it is as a recession indicator.

While markets may rebound from the current dip, I don’t think all these recessionary signals and high stock and bond prices can coexist long term. Given my cautious outlook, I suggest investors take profits in holdings that have outperformed, and seek investment options that offer valuation and yield support. For price appreciation, commodities may be worth exploring.

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